Idiosyncratic Volatility, Realized Return, and Implied Cost of Capital

Abstract

I use implied cost of capital as a proxy for expected return in testing the cross-sectional relation between expected return and idiosyncratic risk. I find a positive relation between idiosyncratic risk and expected return and a negative relation between idiosyncratic risk and future realized return. Ex-ante, investors expect high-idiosyncratic volatility stocks to earn 2.4% per year more than low-idiosyncratic volatility stocks, while ex-post, investors lose 8.4% per year by holding the high-minus-low idiosyncratic volatility portfolio. The ex-ante positive relation is robust to different estimation methods of idiosyncratic volatility, as well as return and volatility reversal. The positive relation is also robust to size, book-to-market, momentum, forecasted long-term growth, and analyst-forecast dispersion. The evidence suggests that the ex-ante and ex-post return differential is partly due to the more optimistic expectation of investors towards high-idiosyncratic volatility stocks. The ex-post underperformance of high-idiosyncratic volatility stocks can be attributed to short-term momentum and long-run return reversal. In addition, the return differential is also due to costly arbitrage for stocks with high-idiosyncratic volatility.